Weak Employment Won’t Slow Down Business Activity

Non-manufacturing economic conditions in the United States continued to improve in May, according to the latest ISM Report on Business. The Institute for Supply Management reported that the non-manufacturing index, or NMI, increased 0.6 percentage points on the month to 53.7 percent, indicating that America’s service economy is growing at an accelerating rate.

The news was a mixed blessing to beleaguered equity markets. Echoing market losses around the globe, U.S. stocks were in a downward spiral on Wednesday. Pessimism began in Japan where the Nikkei index closed down 3.83 percent after Prime Minister Shinzo Abe failed to impress market participants with the third arrow of his economic revival strategy. The bad mojo continued to build with a weaker-than-expected payroll report from ADP, which showed that just 135,000 jobs were added in May. The NMI report did little to boost optimism.

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In fact, interest in Wednesday’s economic reports could be boiled down to enthusiasm for monetary intervention, which has been a primary catalyst for market gains around the world. Japan has been engaged in unconventional monetary policy off and on for years as it struggles against long-term stagflation. The financial crisis in 2008 prompted the U.S. Federal Reserve and the European Central Bank to begin getting creative with monetary policy, and markets have become addicted to accommodation over the past few years.

This addiction has pushed the eventual tapering and end of programs like quantitative easing into the spotlight. The Fed has promised to keep policy responsive to incoming economic data, and Chairman Ben Bernanke has made it clear that he is looking at the same labor market data that is available to most investors.

In the U.S., the Federal Reserve is purchasing $85 billion worth of mortgage-backed securities and bonds each much. These purchases have four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates. Quantitative easing is similar to normal monetary policy in that it puts downward pressure on nominal and real interest rates.

Although the NMI report suggests that non-manufacturing conditions are improving (various reports indicate that manufacturing conditions are not), the Fed has made it clear that they are paying the most attention to labor market conditions. With that in mind, the employment component of the NMI actually fell 1.9 points to just 50.1 percent, barely above the line dividing growth from contraction.

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Taken together with the ADP employment report, the data released on Wednesday suggests that labor market conditions are not quite where the Fed wants them to be. This could mean prolonged asset purchases under quantitative easing, the thought of which is usually enough to spur markets higher. However, they seem to have been frightened, at least for today, into taking profits.

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